Section 7: Economics and Critical Thinking

Critical thinking is particularly important in today’s Internet society and world of information overload and fake news. Authors, journalists, economists, politicians, talk-show hosts and even Hollywood celebrities and famous athletes make controversial and sometimes contradictory statements and express their opinions about social, political, and economic issues. It is useful to read their statements and to listen to their opinions. However, as educated citizens and critical thinkers, we must question everything. If we don’t, we could end up with laws, regulations, and economic policies that harm our economy and our country.

When we evaluate a normative statement (for example, we should raise taxes on the rich) or question a positive statement (for example, if we raise taxes on the rich, then the government’s deficit will decrease), what do we look for? Below are some guidelines.

Critical Thinking Guidelines
When evaluating a statement we must

1. Question the source.
Study the background of the person making the statement. If a union leader provides arguments and statistics to support her/his claim that trade restrictions are beneficial to the American economy and that free trade leads to increased unemployment, we need to consider the source. The union leader’s objective is to represent her/his constituency (union workers). Therefore, (s)he is biased and will make arguments to support her/his union agenda. This doesn’t necessarily mean that the union leader is incorrect. However, when a person is biased, we must be prepared to question the validity of the arguments. This also doesn’t mean that we should not question statements from people who are not biased. We should, of course, evaluate all statements, but in particular from people who have an apparent bias.

2. Question the assumptions. An assumption is information you presume to be true. When in the 1990s Washington, D.C., Mayor Marion Barry wanted to raise more revenue for his city, he and his city council decided that imposing a higher tax on gasoline would do the trick. They made the assumption that gasoline is a necessary good and, therefore, “inelastic.” In microeconomics we learn that buyers of an inelastic product will not change their purchases of this product much when the price changes. Let’s say that, for example, the tax was 30 cents before the tax increase, and people were buying 1 million gallons per month. Then the tax revenue to the city was 1 million times 30 cents, or $300,000. The mayor and his council raised the tax by 10 cents, and they expected buyers to purchase approximately the same amount of gasoline after the tax increase. If so, this would mean that the city’s total tax revenue would now be 1 million times 40 cents, or $400,000. However, after the tax increase, the city discovered that total tax revenue actually decreased (to less than $300,000). It turned out that their assumption about the inelastic nature of gasoline was wrong. After the tax increase, many buyers decided to purchase gasoline in neighboring Virginia and Maryland.

Far fewer buyers bought gasoline in Washington, D.C. In other words, whereas gasoline in the entire United States market may be inelastic, gasoline in the Washington, D.C., area alone is elastic. Several months after the tax increase, Mayor Barry and his council rescinded the 10 cent tax increase.

3. Question how the variables are defined. Economists Card and Krueger conducted what is now a well-known study about the effects of a minimum wage increase in New Jersey. New Jersey, several decades ago, had increased its minimum wage by $1. Card and Krueger had noticed that within a brief period of time following the increase, employment in New Jersey had gone up, despite the higher wage. Card and Krueger concluded that an increase in minimum wage increases employment and decreases unemployment. But when other economists questioned this study, they found that Card and Krueger had used a definition for “employment” that was questionable. Card and Krueger defined “employment” as the number of people, full-time as well as part-time, employed. After the minimum wage increased, many businesses, in order to cut costs and compensate for the higher wage, decided to increase their hiring of part-time workers at the expense of hiring full-time workers. The following example illustrates the flaw in the definition Card and Krueger used. When 500 full-time workers are employed, they work a combined 20,000 hours (500 times 40 hours). When 300 full-time and 300 part-time workers are employed, they work a combined 12,000 (300 times 40) plus 6,000 (300 times 20), or a total of 18,000 hours. Even though Card and Krueger’s “employment” increased (from 500 to 600 workers), the total number of hours worked decreased (from 20,000 hours to 18,000 hours). If Card and Krueger had defined employment as the total number of hours worked, they would have concluded that an increase in the minimum wage decreases employment.

For a video explanation of the importance of properly defining economic variables, please watch:

Another example of how defining a variable can lead to incorrect conclusions involves the definition of Gross Domestic Product. Gross Domestic Product is defined as the sum total of a country’s production of final goods and services. Because of the inclusion of only final goods and services, most products included in GDP are consumption goods. Intermediate goods are excluded. These are typically goods exchanged between businesses and include the flour sold by the miller to the baker, and the screws and machinery parts sold by the parts factory to the car manufacturer or furniture maker. The sale of intermediate goods, spare parts, and raw materials is an important component of our economy, and provides millions of people with jobs. However, this economic activity is ignored in the definition of GDP. To conclude that a country’s total economic activity is made up of mostly consumption is, therefore, false. It is true that GDP is mostly consumption. However, a country’s total economic activity is more than the items included in GDP. Thus, when economists and politicians claim that in order to grow our economy, we should primarily focus on stimulating consumption, they are committing a fallacy based on an incorrect application of the definition of an economic variable.

4. Question the validity of the statement. A statement’s validity often breaks down because of two common fallacies. These fallacies are the fallacy of cause and effect, and the fallacy of composition. The latter is also called the “fallacy of what you cannot see”, or the “broken window fallacy”. We touched on this fallacy in our last unit (see also Henry Hazlitt’s Economics In One Lesson, Chapter 2).

People suffer from the fallacy of cause and effect when they conclude that just because event A occurs before event B, that A must have caused B. Event A could have caused B, but it is incorrect to automatically conclude that A causes B just because A precedes B. For example, European economists have observed growing technology during the past several decades. They have also observed growing average unemployment rates in most European countries during the past decades. Many economists have therefore concluded that growing technology causes greater unemployment. The fallacy is that they are omitting other variables, which may have caused the increase in unemployment. Perhaps increases in tax rates, or increases in protectionist measures, regulations, generous welfare programs, etc., contributed to the rise in unemployment.

People suffer from the fallacy of composition when they conclude that just because something is good for one group or industry, then it must be good for the entire country. Henry Hazlitt’s Broken Window Fallacy illustrates that when a boy breaks a baker’s window, it doesn’t stimulate the economy. Hazlitt admits that the glazier (window repair person) gains a job, just like construction companies gain jobs from natural disasters, such as hurricanes and floods. However, the baker loses money, because he has to spend $250 to repair the window. He subsequently cannot buy a $250 suit from the tailor (this is foregone economic activity that you cannot see when the baker has to repair the window). Analogously, citizens struck by a hurricane (or their insurance companies) now have less money to spend on goods and services they would have otherwise bought (for example, vacations, a new car, etc.) had they not needed to repair their houses. Hazlitt reminds us that one of the keys to economic thinking is to study the effects of economic action on all groups (the glazier, the baker, and the tailor), and not just one group (the glazier).

5. Question the statistics. Be careful when analyzing statistics. Let’s look at the following example. A business earns a profit of $100 in year 1, and a profit of $120 in year 2. It reports to the media that its profits increased 20% (a $20 increase as a percentage of the $100 first year profit). In year 3, profit declines again to $100, and the business reports a decrease in profit of 16.7% (a $20 decrease as a percentage of the $120 profit in year 2). Looking at the percentage changes, it appears that the business is better off in year 3 compared to year 1 (a 20% increase and a 16.7% decrease). However, in looking at the absolute dollar changes, we know that the profit is the same in year 3 compared to year 1. Statistics can be deceiving if incorrect formulas are used or the wrong calculations are made. In the above example, a better method of calculating the percentage change for this business is to apply the so-called arc formula. This formula takes the change in the profit divided by the average of the two years’ profits. In the above example, using this formula, the percentage change is $20 (the change) divided by $110 (the average of $100 and $120), or 18.18%. Notice that the percentage change is the same whether the profit increased (year 1) or decreased (year 3).

Another example of deceiving statistics arises when looking at changes in income inequality. Let’s say that in 1985 the richest 20% of the income earners in our country earned 49% of the total income, and that the poorest 20% earned 5%. Let’s say that we noticed that the numbers for the this year changed to 50% and 4%, respectively. Can we conclude that the rich have gotten richer and the poor have gotten poorer? Looking at the percentage earnings only, this is a correct conclusion. However, looking at real dollar earnings, or standard of living, the conclusion may be different. The reason for this is that in this year, the total income of the country is bigger than in 1985. For example if the country’s total real income in 1985 is $100 billion (hypothetically), and the total real income in the current year is $200 billion, then the poor are making $5 billion (5% times $100 billion) in 1985, and $8 billion (4% times $200 billion) this year. In absolute real dollars, the poor have gotten richer, not poorer.

Some economists are concerned that average wages of middle class households have stagnated because they notice that statistically average wages have not increased much. Be careful with statistics though. It is possible that average wages declined because many high earning persons retired (baby boomers) and are being replaced by young, low earning workers. For example, if workers A, B, and C make $80, $70, and $30 per hour respectively, then the average wage is $60 ($180/3). If worker A retires and is replaced with a young person earning $20 per hour, then the average wage drops to $40 ($120/3). Even if workers B and C received significant raises, the average wage may have gone down. For example, if workers B and C now earn $85 and $45 respectively, and the incoming worker earns $20, then the average wage is $50 per hour ($150/3). This illustrates a situation where significant economic growth has increased existing workers wages, but the average wage has dropped. Everyone should be happy with this progress even if average wages have decreased.

Statistical conclusions based on short-term outcomes may be correct, but long-term effects need to be considered as well. If the United States Federal Reserve restricts the money supply today, and within the next six months, the nation’s unemployment rate increases, people may conclude that a tightening of the money supply causes a rise in unemployment. However, the unemployment rate may fall after one or two years. When the Federal Reserve restricted the money supply in the early 1980s, interest rates rose in the beginning because of a shortage of bank reserves. However, in the long run, as a result of the tightening of the money supply, inflation decreased, and interest rates fell. Unemployment significantly fell thereafter. The converse can occur as well. If a country’s central bank significantly increases the money supply, unemployment will fall in the short run, but rise in the long run (because of higher inflation).

6. Think like an economist. Thinking like an economist means doing everything described in 1 through 5 above. Furthermore, economists use marginal benefit and marginal cost analysis. For example, does it make sense to eliminate all pollution in our society? It would be far too costly to eliminate every single instance of air, water, or noise pollution. However, the marginal benefit may equal the marginal cost (the optimum point) when we eliminate, say, 50% of the existing pollution.

When giving the solution to a problem, consider alternative solutions, pros and cons, pluses and minuses. It is not enough to support an economic program just because it adds benefit to our society. We also have to ask if the program is the best alternative. In other words, does it add the most benefit? The United States Social Security program has undoubtedly benefited many people, including the elderly, widows, disabled, and orphans. However, to ask whether we should support this program, we must also ask if this program is the best program. Can another program (for example, a privatized program or a reformed government-controlled program) deliver even more benefits? In another example, when the government bailed out Chrysler in the 1980s, it prevented Chrysler from laying off thousands of people, and it appeared to be a success. The real question, however, is not whether the government bailout was beneficial, but what would have happened if the government had not spent this money and how many alternate jobs this would have created. Could this have made the economy even better off?

Proper economic thinkers know to analyze the effects of a policy not just for one group, but for all groups (a technology improvement usually eliminates some jobs, but overall it creates jobs). And they know to consider not just the short run, but also the long run (restricting money supply growth may increase unemployment in the short run, but decrease unemployment in the long run).

Economic thinkers know to use common sense. Does the conclusion of a study violate the general principles of economics? If the minimum wage increases and employment increases, does this make sense? After considering the law of demand, it does not. If we do observe an increase in employment in the real world after a minimum wage increase, what is the reason? Were the definitions of the variables applied properly? Were the assumptions correct? Was the minimum wage below the market wage before and after the increase (in which case, an increase in the minimum wage does not change the actual wage – see Unit 2)? Furthermore, economic thinkers do well to be open-minded and non-judgmental. Look at all the numbers from an unbiased perspective and consider that anything is possible, regardless of any political agendas you may support, and regardless of what the majority of the population believes (the majority is not always correct).

Andrew Bernstein quotes Ayn Rand (pictured) in The Capitalist Manifesto (Bernstein A., 2005, P. 196): “The virtue of rationality means the recognition and acceptance of reason as one’s only source of knowledge, one’s only judge of values and one’s guide to action.” Bernstein continues: “This means that in every aspect of one’s life – in education, in career, in love, in finances and friendships – one must conduct oneself in accordance with as rigorous a process of logical thought as one can conscientiously muster.” (Bernstein A., 2005, P. 196). Think critically!